Martin Lefebvre
Hi everyone. I'm Martin Lefebvre, Chief Investment Officer at National Bank Investments. Welcome and thank you for tuning into our NBI Podcast series on the markets. Today we are going to talk about private debt and to do so let me introduce you to my guest, Jason Mandinach, of PIMCO. Welcome, Jason.
Jason Mandinach
Thank you, Martin. It's great to be here.
Martin Lefebvre
Jason, if you want, let's start with credit and then we'll turn it into your real estate. So, my first question is twofold. What type of trends are you seeing right now in the markets that are driving growth in private credit? And secondly, how can investors capitalize on these opportunities?
Jason Mandinach
Absolutely. There are a couple of things I'd say. And before I answer that specifically, I think just a bit of background on how we got here in private credit, because there's been so much growth over the last 10 years or so. So much of the initial growth in private credit started in a very low-rate environment with tight public credit spreads, and people were looking for alternative ways to generate income. Then growing concerns of higher rates and ultimately a migration to higher rates.
And because so much of the stock of private credit was floating rate. To your question of what's been driving the growth, a lot of the growth in private credit has been due to the fact that we've been in a long 10 plus year run of low interest rates, relatively tight public credit spreads, a migration to higher rates. And there's been a lot of enthusiasm for floating rate, higher yielding credit, much of which was on the private side.
That's kind of how we got here today. What's interesting is you're still seeing a lot of focus on private credit, yet the starting conditions today are quite different, where you actually are seeing higher yields in traditional public fixed income as a starting point. They've backed up a bit here over the last couple of weeks even. And so, I think the drivers are a bit different today, and that it's much more about the regulatory backdrop of the banking sector. And we're seeing banks forced to de-risk their balance sheets, pulling out of lending, sharing risk with private market investors, selling portfolios of risk in the private markets. And so, I'd say one is the market catalyst, which is really bank regulation, pressure on bank balance sheets, stemming from higher interest rates. We saw the regional banking crisis in the U.S. just a few years ago as the initial catalyst.
And then I think there's an investor need aspect. And there's two different things I would highlight here. One is just the simple credit versus equity. Equity valuations are stretched on a variety of different perspectives. And we're seeing higher yields in public markets, higher yields in pockets of private markets. And a lot of investors are just looking at, quite simply, can I go up in capital structure and generate, whether it's high single digit, low double digit, even teens type returns in credit. That can be a very attractive value proposition. So that'd be the first thing. The second thing would be public versus private. Again, I actually wouldn't say that private credit is always much more attractive than public credit. As I mentioned, the starting conditions in public are actually much more compelling today than several years ago. And so, we view it as you should have a higher bar for private credit. And there's a lot of the private credit that does meet that bar. And we'll talk more about that. And then the third thing, diversification within credit portfolios. A lot of investors have increased allocations to things like high yield, leverage loans, corporate direct lending. Given what we're seeing from the banking sector, there's a whole host of opportunities outside of more traditional corporate credit on the private side, whether that be commercial real estate debt, various forms of asset-based lending, residential mortgage lending.
And so the investor need for diversification is another key trend that we're seeing in private credit.
Martin Lefebvre
Gotcha. We'll come back to the diversification in a moment. I got some further questions on that, but just to let you know, most of our investors are long only, mostly plain vanilla asset classes. So when you compare private credit or private debt to traditional fixed income securities, in terms of risk and return profiles, what types of benefits do you see and what they tend to offer to investors?
Jason Mandinach
Yeah, so look, first, why don't I start with the similarities. The similarities, just like public credit and private credit, you see higher grade, know, investment grade or investment grade like risk, and also higher yielding or slightly riskier credit instruments. You also see the ability to lend to different areas of the economy, right? There's just in the public markets, have corporate credit, CMBS on the commercial mortgage side. You have residential mortgage related securities, and you have other equipment, aviation, finance type securities. On the private side, you have the same exact dynamic. So those are the similarities.
The differences are on the private side, typically, these are deals that are less liquid as a starting point, that oftentimes have a bit more complexity, either to the underwriting or the structuring of the transaction, which results in an illiquidity premium or a higher yield that you can generate by going from public markets to private markets. In certain areas like asset-based lending right now, that premium can be as high as 200, 300, 400 basis points. In corporate markets, there's actually been more of a convergence between public and private credit. You still have a return pickup in private credit. But for similar quality risk, it's anywhere from call it a hundred to a 150 basis points typically So a bit tighter there and the main reason for that is there's just been a lot more capital formation So a lot more capital raised to address the corporate market opportunity Whereas we're seeing a less competition in some of the asset based and real estate related forms of private credit.
Martin Lefebvre
Jason, you talked about similarities with more traditional fixed income securities. So, what type of correlation would you get by investing in such securities? What type of diversification with the investors get by going into that type of securities?
Jason Mandinach
So look, I think that when you go into a resilient, well underwritten portfolio of private credit, you should be able to reduce correlations to three key areas. One, reduce your correlation to equity markets. Second, reduce your correlation to what we would call higher beta credit markets, so things like high yield or leverage loans. And third, reduce your correlation to traditional fixed income measured as something like the Barclays Aggregate Index. Now the strategy itself will dictate what those correlations ultimately look like, but we run a variety of strategies here at PIMCO that can reduce those correlations well inside of 0.5.
Martin Lefebvre
Okay, where does that de-correlation or under-correlation come from?
Jason Mandinach
It comes from variety of different factors, right? One is you just noted, the good or the bad thing about private credit is that it's typically marked on a less frequent basis. Oftentimes private funds are marked on a quarterly basis. Some of the newer semi-liquid funds are marked on a monthly basis. So that alone reduces your day-to-day volatility with some of the more public benchmarks that I mentioned.
There's also certain risk is more floating rate in nature, which has benefited from rising rates. We would argue, by the way, that that may work against you in a falling rate environment because your coupon's also going a bit lower. higher rate volatility is not always great for floating rate credit, but it's worked well to date. And then third would be some of the strategies themselves. There are forms of private credit that are just less correlated to traditional forms of risk. Some extreme examples that have gotten the headlines recently, you know, buying music royalties portfolios would be an example of that. Aviation finance, you know, buying aircraft and leasing them out would be another example of something that's typically less correlated to traditional debt and equity markets. So, I'd say it's a combination of those three things.
Martin Lefebvre
Okay, excellent. All right, so let's switch gears and turn it into some real estate debt questions. So, you know, there's different structures, whether it's senior loan, mezzanine, or even CMBS (commercial mortgage-backed securities). So which type of securities do you find the most attractive on a risk adjusted returns in the current market environment?
Jason Mandinach
So, I'd say on the real estate side, there are two areas that we're most focused on. One would be senior lending. So really stepping in is a high-quality senior lender, specifically focusing on transitional real estate debt. Still keeping loan to values well inside of the 60, 65% range. You can do this by the way, avoiding some of the riskier areas like office and staying relatively up in quality in areas like logistics, like multi-family, like data infrastructure.
And unlike some of the dynamics that I mentioned in the corporate direct lending space, as you and your listeners probably know, real estate has not exactly been an area that's been an area of enthusiasm for a lot of investors in recent years. And because of that, it's been harder for many managers to raise capital. Some of the existing lenders, whether it's banks or mortgage REITs or even other debt funds have been playing more defense than offense in this space. And so, it really does create opportunity for flexible, well-capitalized lenders to step in and provide senior transitional financing at attractive spreads, attractive all-in yields with some upside from there because you can apply leverage to some of these assets. So that would be one area of focus for us.
The second would be what I would call more capital solutions. The first was more of kind of a step out from public credit. And there's a lot of good assets with challenged capital structures, given how things were underwritten in a low-rate world with the expectation of continued rising asset prices on the real estate side. So those would be the two areas to us that stand out on a risk adjusted return basis. One is again, within kind of the performing credit world and the other more as kind of hybrid capital and competing with equity like returns.
Martin Lefebvre
Jason, I got one last question for you. Real estate is often seen as a steady stream of income. So how can these type of instruments be structured to align with investors' income and capital preservation objectives?
Jason Mandinach
So, look, I think on the first area, the transitional real estate lending can really play a key role from that standpoint in that you're talking about well underwritten senior in the capital structure lending against assets that we think have a great deal of resiliency across a range of different economic scenarios. In many ways, this is the type of return profile that looks more like what you mentioned, buying a building several years ago and benefiting from the stable income stream of that building. And so that would be the biggest thing is going up in capital structure, senior resilient lending against assets that we think can perform across a range of economic scenarios and generate unlevered high single digit type yields, that aligns quite well with a lot of investors' objectives. If you can generate high single digit type returns with really strong downside protection, low volatility, limited risk of real principal impairment, we think there's a lot of demand for that. And real estate is oftentimes an area of the market that investors are under allocated to. And so going back to one of your earlier questions on diversification, it can play a critical diversification role in a portfolio that's typically quite focused on traditional cash flow lending.
Martin Lefebvre
Jason, this was all the time that we had. Thank you very much for participating. It was very interesting and much appreciated. And for everyone online, thank you for listening. Our NBI Podcast series will resume next month. Thank you.
Jason Mandinach
Thanks Martin. Really appreciate your time.
Martin Lefebvre
